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Opinion CLOs
CLO equity players may be better off remaining flexible across channels
by Dagmara Michalczuk
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
Investors needn’t commit to either Paris or London
In his novel A Tale of Two Cities, Charles Dickens juxtaposes the relatively stable realities of 18th century London against the unpredictable, and at times violent, revolution unfolding in Paris. Beyond featuring one of the greatest opening lines ever written (“It was the best of times, it was the worst of times…”), the novel’s contrasts remind me of how primary and secondary CLO equity investing strategies are often depicted as vastly different.
Primary CLO equity investing involves purchasing a stake in a newly created CLO during its formation process (or as part of a reset or restructuring), typically from the underwriting dealer or the CLO issuer itself. Secondary CLO equity investments, by contrast, involve purchasing existing tranches from current holders after the CLO has already been issued, with fully ramped portfolios, established structures and documentation.
Initial advantages for primary buyers
Primary CLO equity buyers, particularly controlling investors, can have significant influence over CLO structures, initial portfolio construction and terms, including manager selection and fees. They also assume some execution risk on CLO debt pricing and loan portfolio acquisition — and face slightly longer first distribution periods than investors in fully ramped deals.
On the positive side, new issue CLO portfolios are generally ‘cleaner’ than more seasoned pools. They also have longer reinvestment runways than deals available in the secondary market. Additionally, when capital markets are functioning, primary CLO equity investors can drive as much equity creation as they desire, rather than passively waiting for positions to become available for sale.
Importantly, the primary CLO equity investor base has changed over the past decade, with more CLO issuance now financed by captive or affiliated capital. Unlike opportunistic third-party investors, this capital may have goals beyond maximising equity IRRs, including expanding CLO AUM and management fees. As a result, parts of the primary market today may be less sensitive to initial equity arbitrage levels than in the past.
This dynamic can weaken equity investing discipline while, somewhat paradoxically, supporting higher CLO issuance. At the same time, captives may also be less inclined — or unable due to risk retention commitments — to sell positions, potentially reducing secondary supply.
Secondary equity investors have no ability to influence a CLO’s features and must instead evaluate each equity tranche as it exists at the time of purchase. Because they depend on willing sellers, secondary buyers also cannot control or reliably predict how much supply will be available, nor its characteristics (for example, minority versus control). That said, secondary trading activity can exhibit some seasonality, with BWIC volumes often rising after CLO payment dates.
Mercurial secondary market is like Paris
Secondary CLO equity prices, however, tend to be more volatile and dispersed than new issue equity, as they are more directly linked to underlying equity NAVs. Positions trade at a premium or discount depending on portfolio quality, structural health, expected cashflows, reinvestment optionality and manager perception, among other factors. This can make the secondary market particularly attractive for sourcing equity during periods of stress. In more severe downturns, CLO issuance can shut down, leaving the secondary market as the only avenue for deploying capital into CLO equity.
Some investors find the secondary CLO equity market exciting because it offers a wide diversity of deal profiles, operates largely through competitive (and at times opaque) auction processes, and is generally more time sensitive than the primary market. Investors may have only hours to evaluate secondary positions and submit bids. In the context of A Tale of Two Cities, this frenetic and mercurial market would be most like Paris.
At the end of the day, however, both strategies face the same uncertainties and require investments to be evaluated through the lens of risk-adjusted returns. With the length of the current credit cycle and duration of potential distress still unclear, preserving strategic flexibility becomes increasingly valuable. As much as investors may favour one market over the other, the optimal approach for active CLO equity players may be to remain flexible across both channels for investments and exits, dynamically adjusting strategy as market conditions and outlooks evolve.
